Australian Currency to Remain Investment Target

The Australian dollar is losing its connection to the ups and downs of commodity prices now that global investors are using it to prop up their investment returns. But complaining import competing manufacturers should recall what it was like for them when they had a weak dollar.

Conventional wisdom has the Australian currency linked inextricably to commodity prices. It is widely described in financial markets as a "commodity currency".

The connection has been most pronounced over the past 10 years as commodity prices increased better than fourfold (based on the IMF metal price index) and the exchange rate with the U.S. dollar leapt from a historic low of 49¢ at the end of March 2001 to a peak of 110¢ in July 2011.

Particularly for those used to characterising economic relationships in short term charts, this has been conclusive enough evidence of the strength of the bond.

The experience over the 20 years between 1981 and 2001 shows something different. The currency went from US115¢ to 49¢ over a period in which commodity prices were little changed.

On a more complete viewing of the evidence, a conclusion about a relationship becomes less certain.

Modeling the exchange rate seems to involve more than simply a view about commodity prices. Inflation, trade balances, national debt, political risk and relative investment returns will all have an impact. Like so much in economics, the causal links are complex and vary over time.

Higher commodity prices will improve the country's trade position, for example. Are commodity prices, therefore, simply a surrogate for the balance of payments? And, if so, could a balance of payments improvement from any other source, while commodity prices were even falling, have had an equivalently uplifting effect on the currency?

High commodity prices could, as now, result in large scale investments requiring unusually large capital inflows which, presumably, support a higher currency but which also bring higher national borrowings, presumably a negative influence.

A relatively high inflation rate in Australia coincided with a declining exchange rate through the 1980s. The falling exchange rate itself aggravated a pre-existing inflation problem which formed a circular link through wage increases to higher inflation and a still weaker exchange rate.

Profit margins were under continual threat, the level of foreign currency denominated debts skyrocketed and investment returns were unattractive for investors.

The most recent strength in the Australian dollar came after significant improvements in Australia's productivity and inflation performance and record levels of business profitability. Would the currency have remained strong irrespective of these conditions as long as commodity prices were on the rise?

While there has been an upsurge in talk about the end of the commodity boom in recent weeks, the currency has not been reacting to the end of the cycle as many had anticipated. The Reserve Bank itself seems to have been caught off guard by the resilience of the currency "despite a deterioration in the global economic outlook and a decline in the terms of trade", according to its 10 August quarterly monetary policy report.

Talking to investors during my own trips overseas in recent months had highlighted a marked change in view about the way in which an investment in Australia was perceived.

Investors have been sending their money to Australia for a combined yield and exchange rate gain of 7-8% at a time when the risks in Europe and the USA were on the rise. The temptation has been irresistible.

The Australian economy was thought of by many as a safe haven investment destination. In a world in which interest rates had been tumbling, Australia stood out as offering a superior return on savings. The quest for yield was bringing investors to Australia. Australian bonds were the new iron ore.

We know from various sources that the flow into Australian government securities is not just from individual investors. Central banks have been putting reserves into Australian bonds in an attempt to diversify their asset exposures.

Australian manufacturers, along with the central bank, have appeared to be holding their breath in the hope that once commodity prices began to fall so, too, would the currency. If they could just hold out long enough, things would revert to normal. That hope may have been misplaced.

The logical course would be to facilitate a lowering of interest rates if that is what is attracting offshore funds. However, the RBA is reluctant to move in that direction because the labour market remains problematic as a source of inflation pressure as long as high levels of investment expenditure are persisting in the mining sector. That could be the case for a few years yet.

The only sure way to get the currency down might be some old fashioned poor economic management of the sort Australia had in the 1980s that allows inflation to accelerate, productivity to flounder, profit margins to disappear and debt levels to burst their current barriers.

While our political leaders might occasionally skate close to the line dividing competence from muddled thinking, they are generally not offering manufacturers much comfort that currency relief from this source is near at hand.

If the unemployment rate starts to rise because the continuing exuberance for Australian investments among foreign investors keeps pushing the dollar higher, the pressure will mount on the Reserve Bank to use interest rates to drag the currency lower. But there is no telling how much rates will have to fall to dissuade investors about the safety of their new found haven.

The message to absorb for many urging a lower currency is that exchange rates are relative prices. Commodity prices could tumble from where they have been sitting without the expected impact on the currency as long as Australia continues to stand out as a place in which to park investible funds.

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